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Is the Bond Bubble Finally Bursting?

Encouraging economic news could soon spell bad news for your bond portfolio. With the latest jobs report showing continued forward momentum, the unemployment rate dipping ever so slightly to 8.8 percent, and CEOs sounding more upbeat than they have in years, odds are growing that the low interest rates aggressively manufactured by the Federal Reserve to stimulate the economy may soon be ending. And at the point the Fed does scale back its role in the bond market, it becomes increasingly likely that the long-anticipated end to the bond bubble may finally materialize.

Granted, calls for the end of the bond market bubble have been percolating for a few years now. But don't mistake being too early with being wrong about where we're headed. The epic bond bull market that began in the early 1980s has been fueled by a sharp decline in yields; the 10 year Treasury has fallen from 13.6 percent in 1984 to under 4 percent today. With the yield limbo bar now so low, it's hard to make a case for bullish price appreciation going forward; remember you need falling yields to generate rising prices in the world of bonds. And we've been in a state of suspended animation the past few years given the Fed's intervention that has kept rates low and added some froth to the bubble. With the prospect of the Fed being ready to change course a bit in the coming months, though, we could finally see the bubble burst. Here are some factors to consider:

1. The Federal funds rate may finally rise off the mat. The Federal funds rate has been stuck at 0.25 percent since 2008 in an effort to make money cheap enough to help the economy pull out of the recession. Now that economic growth seems to be well on the mend -- albeit not as resoundingly strong as is typical for recoveries -- the noise is growing that later this year or early next year the Federal Reserve will start to increase its target Federal Funds rate. Narayana Kocherlakota, President of the Minneapolis Federal Reserve, told the Wall Street Journal last week that the uptick in inflation suggests the Fed Funds rate might rise by more than half a percentage point by year-end. And that would likely just be the start of a longer-term tightening cycle.

2. The long-end of the bond market will be required to stand on its own two feet. Come June 30th, the Federal Reserve's $600 billion bond buying program aimed at keeping rates low on the long end of the yield curve is scheduled to come to an end. The current betting is that the Fed will not step in with QE III. That means the market will lose its buyer of first resort. When that happens, the private market will likely demand higher yields before it is willing to step in and buy.

3. The federal deficit and debt load is no longer the elephant in the room. While Washington is still arguing over whether to cut federal spending $36 billion or $61 billion in this current fiscal year, that's sort of chump change when we've got a $1.5 trillion federal deficit and nearly $15 trillion in federal debt. There's no telling when Washington might actually take a serious run at them, but now it's more a question of when and not if. In the meantime, the likes of Pimco's Bill Gross and Berkshire Hathaway's Warren Buffett are on the record saying that our massive debt obligations -- Gross puts our federal debt at $75 trillion when factoring in Social Security, Medicare, and Medicaid -- means higher inflation and a weaker dollar, which is not exactly great news for Treasuries. In fact, long-term Treasuries were having a pretty bad first quarter until the Mideast uprising and the Japanese earthquake sent prices back up as the U.S. market became a safe haven. The 10-year Treasury yield had jumped from 3.3 percent in early January to 3.75 percent a month later, before falling back to 3.5 percent by quarter's end.

One mitigating factor that could keep yields from rising is if the economic recovery were to stall out later this year. That's not exactly out of the question if oil prices keep rising and consumer confidence keeps falling. But again if that were to happen, it's not likely to set off a big bond rally -- we have little room for that -- but simply forestall when the market pivots to higher rates.

All that's an an argument for leaning toward the shorter-end of the yield curve regardless of the exact timing of when rates do start to rise.

Be Careful in the Junk Yard
The Fed's mission to keep interest rates near historic lows has recently caused investors to load up on high yield bonds that offer enticing yields of 7 percent on average. EPFR Global says fund flows into junk funds totaled $15.5 billion in the first quarter; that's 63 percent more than inflows during last year's first quarter. Clearly we're more willing to venture into junk amid an improving economic picture. And the Wall Street Journal reports that corporations are busily floating new junk; a record $114 billion in new junk bond issues hit the market in the first quarter of this year.

Be careful substituting junk bonds for high-grade issues, however; the two are very different animals. In many ways, junk is more like a stock than a bond. That has its upside: junk is less sensitive to rising interest rates as its value is determined more by an issuer's ability to make good on the payments and the general economic outlook. Granted, both are looking better right now, but keep in mind what can happen when we hit a rough patch. In 2008, an index of high yield issues fell 20 percent, while an index of high-grade bonds gained 5 percent. As MoneyWatch's Larry Swedroe has repeatedly laid out, junk is the last place you want to be when the market heads south.

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